In the Mortgage World, Interest Rates Aren’t Everything

When prospective homebuyers consider purchasing a home, the first question they want answered is, “what are the current interest rates?” In 2014, the United States experienced a massive refinancing boom as a result of interest rates reaching record lows of a 3% range on average. While interest rates are still being observed at record lows, prospective homebuyers are timid in their decisions and treading very lightly as the result of the treacherous path since the financial crisis.

The first 2 quarters of 2014 left mortgage analysts feeling stumped. After the Federal Reserve began significantly shaving down their stimulus plan, the expectation was that interest rates were about to skyrocket. Instead, the opposite situation occurred. Interest rates inched up for a short period of time, but eventually fell back down to about a 4% range on average. When mortgage interest rates increase, it indicates strength in the economy, because interest rates are driven down when the data released on the economy is much weaker than expected and also when war, disaster, or calamity occurs in the world. Both of these factors cause investors to put their money in mortgage-backed bonds because they are viewed as safe investments in uncertain times. Bond purchases and interest rates are inversely related. When there is a high demand for bonds, mortgage interest rates are driven down. When things are in all well in the world, both economically and socially, interest rates are higher because less investors are putting their money in mortgage-backed bonds and instead they are making more risky investments. However, despite the fact that interest rates are at record lows, homebuyers are nowhere to be found at a time when analysts predicted that prospective homebuyers would be flocking to purchase homes.

To better understand the big picture, lets zoom out and visit the extremely volatile environment that the mortgage industry breeds in an overview. Since early 2005, the industry has been erratic. The boom in the mortgage industry during 2005-2007 was immediately followed by a bust in the industry that led to one of the most devastating financial crises that the United States has seen. As told by Forbes in an article entitled, “Understanding The Trends In Mortgage Originations By U.S. Banks”, low interest rates were leveraged by the United States government in an effort to boost the industry. “As the economy recovered from recession, record-low interest rates coupled with several government-led incentives gave a boost to the industry in 2011-2012 when homeowners rushed to get their mortgages refinanced to benefit from the improved interest environment and lending terms”. While this did last for a short while, eventually low interest rates lost their glamour. Forbes goes on to highlight this, “refinancing activity dried up soon, though, and without much improvement in the demand for fresh mortgages, Q1 2014 saw the lowest mortgage origination volumes since Q3 1997”.

It is safe to say that in the past decade there has been a pattern of boom and bust in the mortgage industry. The environment is so volatile that everyone—analysts, homebuyers, and mortgage brokers/bankers—must adapt. But right now, despite enticing interest rates, prospective homebuyers are not budging, which means that right now they are the ones who wear the pants in this relationship. Many prospective buyers are acting like this also because they want to wait until interest rates return back to the point they were at in 2013. In their eyes, even though interest rates are at ‘historic lows’ that 4% average vs. 3% average is looking steep when it stands alongside rising home prices. The Wall Street Journal’s national economics correspondent, Nick Timiraos, brings up an interesting perspective in the way that he believes consumers are looking at this matter, “in the same way that shoppers may not be lured by ‘low prices’ at a department store that is always advertising a sale, mortgage rates at 4.1% may not be seen as a steal by buyers who lived with rates that were even lower for all of 2012 and the first half f 2013—especially considering that prices have moved higher”. Buyers are currently ignoring these rates because in their eyes it still could be much better. Nick goes on to ask the question, “which change is more dramatic-a decline in interest rates from 5% to 3.5% over the two years beginning in February 2011 or the decline from 4.5% in January to 4.1% in May”? According to the data, the answer is the decline from 5% to 3.5%. See the figure below which depicts this:

*click for enlarged image

It is clear by looking at this graph that 2013, represented by the green line, exhibits the most dramatic shift in interest rates over the past four years, and it seems that based on homebuyer activity, prospective buyers think that if it can happen once, it can happen again. Nick Timiroas states that, “the speed with which rates rose last year could have dented demand in the short run”.

In terms of the way that analysts predicted the housing market to exhibit more recovery right now than what is currently being demonstrated, there is good reasoning for why we have had a ‘false sense of demand’. Goldman Sachs economists, Sven Jari Stehn and David Mericle recently reported, “as this tailwind dissipates going forward, the trend in housing activity might be somewhat lower than previously assumed”. Economists at the Federal Reserve Bank of Cleveland finished this thought by stating, “this isn’t to say that the cold winter and the rate jump are the only reasons housing has slowed down. Low rates and prices may have spurred the release of pent-up demand throughout 2012, as home prices began to rise. This one time benefit, together with aggressive home purchase by investors (also a temporary phenomenon), could have given false signals about the true health of the demand side of the market in 2012 and 2013”. Back in March of this year, I wrote an article entitled, “Investor Activity Creates and Illusion in the Progress of Housing Recovery” detailing how investors boosted the housing market which led to analysts misunderstanding where the demand in the housing market was coming from. Now that investors have stopped buying up a lot of property throughout the United States, the truth has been unveiled and it is apparent that perhaps your average homebuyer was not responsible for the small boom demonstrated in the 2013 housing market.

All of this shows us that the housing market is not solely driven by rates. There are plenty of other factors currently adding cement to the stalemate. These factors include the lack of increase in wages throughout the United States, family and job locations, the quality of homes on the market, lack of enough equity for homeowners to sell their homes, and also the rise in student debt. Currently, student loans stand as the single largest debt that Americans carry next to mortgages, and chances are that these Americans are attending and finishing school earlier in their lives than they would a mortgage, and therefore attaining this huge debt first. People feel as though they have enough outstanding debt, that it is hard for them to fathom accumulating any more, and as a result they are kept out of the market. When credit is tight, a lot of change occurs within the economy as a whole. New York Real Estate News Source, The Real Deal, states, “you’re going to see weak home ownership rate, and not much improvement in household formation because student loan debt is still a huge problem”. These factors are pushing people into cohabitation situations rather than becoming head of household – leaving less people to go out and search for a home to buy, shifting the market into a current state of ‘rent instead of buy’. According to The Real Deal, home construction “was driven by a 40% increase in multifamily building. Meanwhile, single-family home construction was up 0.8%”. But at the same time, Bank of America sees the shift toward renting “as a cyclical factor that will improve as the economy recovers”. The prediction now is that is will take years to recover to the point where home buying dominates over renting.

What drives the housing market is complicated and at times convoluted. It is clear that there are a ton of factors that determine whether the housing market is booming or if it exhibits a bust. While this is true, and that the housing market is not solely driven by interest rates, it certainly does play a central role in the direction that the market shifts towards. Put into perspective, a difference of one percentage point in an interest rate can be significant when it comes to monthly payments. According to Zillow, and provided that the homeowner put down a 20% down payment, “the monthly payment on the median-priced U.S. home fell from $673 in February 2011 to $552 in September 2012 as interest rates fell. Interest rates stayed low through May 2013, but the average payment rose to $586 as home prices tickets up…After interest rates jumped last summer, the average payment bounced to $674 in September 2013”. It makes sense that prospective buyers are timid, because they missed the bus to save over $100 per month on their mortgage payment, which results in over a $39,600 difference over the life of the loan. With that extra $39,600, that person could have purchased a much larger house. For homebuyers, opportunity knocks, and does not last forever.

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